Sunday, October 5, 2008

Full Blown? Or Half Hearted?

Now time for some of the interesting questions

Financial crisis: Full blown or half hearted?
The US has a pretty major financial problem brewing. It has spread to Europe as we see Ireland and then Germany guarantees depositors in banks beyond what was their norm. We know about Libor and the interbank finding problems. We have seen various financial institutions in the US in the UK in Belgium and the Netherlands, in Germany in Denmark with their problems. Other banks have been hit with adverse speculation. But will this spread out of the financial sector and will it spread to the sovereign debt and lending markets?

Russia already is having severe stock market difficulties. That owes less to the credit crunch than to concerns over its actions in Georgia. plunging oil and commodity prices also will hit Russia hard. Its economy is more like that of a developing economy and it is going to be hit hard. The risk that this liquidity problem could spread is a clear one.

We have seen the problems hit stocks hard. Last week the S&P industrials sector fell sharply by 12% in the week. Companies with large financial operations such as the auto companies and GE have been hard hit. In the US auto companies have gotten with own special aid package. Even in Europe auto companies are looking for some help on the grounds that getting capital together to invest to meeting the new mileage and emissions standards will be too costly. Everyone is looking for money.

If it spills out into the international lending market it will become a bigger problem. It looks like it is headed in that direction.

US economic downturn: full blown recession or half-hearted slowdown?
The US downturn is looking more severe. That Sept employment report may have had some minor boost from hurricane disruptions. If so next month will certainly have more - jobless claims data tell us that. But beyond those short term technical factors wheat is really cooking with the recession and with job growth? Is it really getting much worse? With the spreading credit crunch betting on a worsening makes sense.

The unemployment rate topped out between 6% and 6.5% the last cycle. In 1991 the rate peaked just short of 8%. Since the late 1950s the unemployment rate has topped out in recessions at 8% on average and just above 7.5% in terms of the median result. But the last two recessions produced average to lower unemployment peaks. The recession's unemployment peak is usually lower if the inflation rate has been lower. But while headline inflation has been elevated in this cycle the core rate really has not. I am more inclined to worry about the financial transmittal and the impact on the economy from that channel than from inflation which has been under control... since I do not call the headline result of the CPI inflation. Core inflation has remained pretty well under control.

On balance the U-rate should peak out around 7% in this cycle. That keeps it short of the average but well above the mild recession mark. The greater role of the more stable service sector and the slowdown in population growth and aging of the population should help to keep the U-rate from surging in this cycle.

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